Should you have to pay off your car loan early? This question may sound like a no-brainer, however the answer isn't as simple because it seems. In some instances, paying down your vehicle loan early can negatively affect your credit rating.
Paying off your vehicle loan early can hurt your credit because open positive accounts have a greater effect on your credit score than closed accounts—but there are more factors to consider too. Before you decide to rush to write that last check to your lender, this is what you need to know.
How Paying Off Your vehicle Debt Early Can Hurt Your Credit
Whenever you are making a major change to your credit history—including paying down a loan—your credit rating may drop slightly. Without having any negative issues inside your credit rating, this drop should be temporary; your credit ratings will rise again in a few months. After it's paid off and also the account is closed, your car loan will stay on your credit history for up to 10 years, and as long as you usually made your instalments on time, the borrowed funds will continue to possess a positive impact on your credit report.
So what's the trouble with paying off your car loan early? Even though closed accounts still affect your credit rating, open positive credit accounts have more of an impact than closed ones. That's because open accounts show lenders how well you're managing your credit right now—not in the past.
If you're trying to establish credit or improve your credit score, keeping an auto loan open could be more helpful than paying it off. For instance, for those who have a thin credit report (meaning you simply possess a few credit accounts), a car loan will prove to add to the quantity of accounts you've, helping to build your credit history. An auto loan likewise helps to enhance your credit mix by diversifying the types of credit you've. Having both revolving credit (for example charge cards that allow you to carry a balance) and installment credit (loans having a fixed monthly payment) can improve your credit rating mix, which will help improve your credit rating.
When Is It a Good Idea to Repay Your Car Loan Early?
There are some situations when paying off your car loan early can be a smart move:
- If you've got a high interest car loan: For those who have a 60-, 72- or even 84-month auto loan, you will be paying a lot of interest over the lifetime of your loan. Paying off the borrowed funds early can help to eliminate the total interest you pay. Prior to doing so, make sure your lender doesn't charge a prepayment penalty for paying off the loan early. (If you have a precomputed interest loan, the quantity of interest you'll pay was calculated and fixed at the start of the loan, so even though you remove the loan early, you've still got to pay for that precomputed interest.)Refinancing a high interest car loan for just one having a lower interest rate is an option to repaying it early. If your credit score has improved or interest rates have dropped substantially since you bought the vehicle, refinancing can reduce your payments, and your credit rating can still benefit if one makes those payments promptly.
- When you need to enhance your debt-to-income ratio: Some lenders consider your debt-to-income (DTI) ratio—the quantity your debt every month in contrast to the total amount you earn—when deciding whether or not to offer you credit. In general, lenders want to see a DTI of 43% or less, however, many lenders prefer ratios below 31%. (Learn more about calculating your debt-to-income ratio.) If you are planning to try to get a home mortgage in the near future, however your DTI is higher than lenders like to see, paying off your car loan early could improve your chances of qualifying for a mortgage.
- When you've additional open accounts: Have you got lots of other credit accounts and a good credit mix (such as a mortgage, a student loan and many credit cards)? If you have an extended credit rating with diverse kinds of credit, paying down your vehicle loan early must only cause a temporary dip in your credit score.
When Is it wiser to Keep the Loan?
Here are a few situations when you are best keeping the auto loan:
- When you've got a low interest loan or 0% financing: On average, interest on car loans is gloomier than you are on a number of other types of debt. For instance, current credit card interest rates average about 17.75%, while car loan interest rates average about 4.75%. If you're carrying charge card balances, paying them down makes more financial sense than paying down an auto loan early. Had you been sufficiently fortunate to get a 0% financing deal when you bought your car? Plus there is really no help to make payment on loan off early. If you have extra cash burning a hole in your wallet with no other debt, invest it (or save it for a down payment on your next car).
- When you don't have an emergency fund: It's advocated keeping 3 to 6 months' price of expenses in desperate situations fund in the event you lose your job or are hit with unexpected expenses. If you don't yet come with an emergency fund, any extra cash should go towards establishing one, rather than paying off your car loan early.
- When you're close to the end of the loan: If you have only a few more loan payments to visit, paying off your vehicle loan early won't save you a significant amount of interest. In this case, it's easier to keep your loan, make those remaining payments promptly, and take advantage of the positive effect this can have on your credit rating. (The only real exception: If you wish to sell your car to a private party, having title towards the vehicle will make it simpler to do so.)
To Pay or otherwise to pay for?
Should you pay off your vehicle loan early? To make the right decision, consider your credit history, credit score and credit mix; the interest rate on the auto loan and potential savings; and if the money you'd spend paying down the vehicle loan in a lump sum are the best spent elsewhere, such as paying down high interest credit card balances or building an emergency fund. If you're not sure what your credit rating is, get a free credit report to check on your credit report, credit score and credit mix.